The Best Pension for You

By Albert B. CrenshawNovember 13, 2005

One of the hottest -- and hardest to understand -- policy battles going on in Washington right now concerns the kinds of pensions that employers should be allowed to offer. The fight features arcane formulas and obscure abbreviations that quickly cause the eyes of most normal people to glaze over.

But if you work for an employer with a traditional pension, or are contemplating going to work for one, you should prop those lids open and follow the battle. Its outcome could determine how much money you end up with in retirement.

As usual in such disputes, politicians and employers have been handing out simplistic assertions about what's good and what's bad. And as usual, these assertions are true in some cases and false in others.

The core of the dispute is whether employers should be allowed to convert traditional pensions to a relatively new kind of plan that has some of the characteristics of the old plan but in other ways resembles a 401(k) or similar arrangement.

These newer hybrids are called cash-balance plans, and hundreds of companies have installed them to replace an older type of pension known as a "final-average-pay" plan.

These conversions have been the source of much controversy, and a federal judge, in a suit brought against International Business Machines Corp., ruled a couple of years ago that cash-balance plans violate federal age-discrimination laws. That's being appealed.

And this month, Congress's Government Accountability Office issued a study that concluded that in a typical conversion, most workers ended up worse off under the cash-balance plan than they would have been under the final-average plan that was replaced.

That part of the GAO report drew immediate applause from cash-balance opponents. Other parts of it, though, have been largely ignored -- and because of limitations on the data available, the study couldn't really look at workers who left these companies and took other jobs.

The question today's workers should be asking is, what's best for me? And secondarily, what can I do about it?

To answer that -- and to see how you fit into the dispute -- you need a general understanding of how these plans work.

First, we are talking here about "defined-benefit" plans, so called because the plan specifies the size pension a worker will get and promises to pay it. Typically, the employer funds such plans -- in some cases workers also contribute -- and is on the hook for the tab. In other words, the company bears the investment risk. Such plans are insured by a government agency, which promises to pay the benefits, up to certain limits, if the employer cannot.

(In "defined contribution" plans, such as 401(k)s, the employer and/or the worker put money in, but the employer makes no promises about what the ultimate benefit will be. In other words, the worker bears the investment risk.)

A final-average-pay defined-benefit plan -- the dominant pension form for the decades following World War II -- provides a retirement benefit that is a function of the number of years an employee was at the company, his or her pay, and a multiplier. In a simplified example, a benefit might be defined as years of service times the average of the highest five years of pay times 1.75 percent. Thus, a worker with 30 years of service and a "high five" of $50,000 would get an annual pension of $26,250 ($50,000 x 30 x 0.0175).

Cash-balance plans are also technically defined-benefit, but they work more like a 401(k) or, in simplest terms, like savings accounts. In such plans, each worker gets an "account," to which the employer credits a percentage of pay each year plus interest. The accounts are hypothetical, meaning they exist only on paper, but they allow a worker to see his or her balance regularly and keep tabs on it. The employer promises to have the money there, for both pay and interest credits, when the worker retires or leaves the company. The balance generally can be rolled over to a new plan or an IRA at a job change, or turned into a stream of pension payments at retirement.

Cash-balance plans, like other defined-benefit plans, are insured by the government.

Both final-average and cash-balance plans can be generous or stingy, but an important difference between them is what happens to the benefits if a worker stays at one company or changes jobs.

If a worker changes jobs, his benefits will be less under a final-average plan than they would be if he stayed at one company for many years -- assuming the same pay -- if all his employers had identical plans.

Compare the example above, where the worker stayed put for 30 years, to the pension of a worker who stayed 10 years each at three companies with identical plans. If his first high five is, say, $25,000; his second $35,000, and his final $50,000, his benefit would be the sum of the benefits he earned at the three companies, two of which would be based on a high five that is lower than the one at the end of his career.

So if all three companies had the same benefit formula as in the first example, the job-changer's pensions would total $19,250 -- versus the $26,250 for the worker who stayed put.

For workers with cash-balance plans, that difference disappears -- assuming the job-changer "vests" at each company and rolls his balance over. The job-changer does better and the stay-put worker worse than they would with final-average plans.

The stay-put worker likely would get a lower pension than if he had a final-average plan, as the GAO found. However, the job-changer likely would end up with the same benefit as the stay-put worker, if both had cash-balance plans, and more than if he had a series of jobs with final-average plans.

"Final average . . . plans are designed to reward career-long service," said Kyle Brown of benefits consultant Watson Wyatt Worldwide. "Cash-balance plans are designed to reflect a more mobile workforce."

This means that if you expect to remain decades at the same employer, you should press the company and lawmakers to provide or retain final-average. And you should urge your representatives to write tougher transition rules to protect you if the employer does convert to cash-balance.

If you expect to jump around, you may want to urge lawmakers to remove the legal cloud hanging over cash-balance plans. If you're going to have a cash-balance plan, the sooner it gets going, the larger your ultimate balance will be.

Finally, preventing employers from having cash-balance plans may ultimately be counterproductive. Unless and until Congress makes pensions mandatory, a company that is unhappy with its final-average plan can terminate or freeze it. And, as the GAO found, most workers are better off with a cash-balance plan than a terminated final-average plan.

The 2006 Ford Escape Hybrid and 2006 Mercury Mariner Hybrid were certified by the Internal Revenue Service last week as eligible for the clean-burning-fuel deduction. This means that taxpayers who bought one of these hybrids new this year may claim a deduction of up to $2,000 on their 2005 return.

The deduction is for vehicles put into service this year, and the taxpayer must be the original owner. But it is not necessary to itemize -- the benefit can be taken as an adjustment to income on Form 1040.

The deduction for hybrid vehicles expires Dec. 31, to be replaced by a credit next year.